Chapter 10: Subsidiary Preferred Stock,

Consolidated Earnings Per Share, and

Consolidated Income Taxation
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

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Preferred Stock, EPS, and Taxes:

Objectives
1. Modify consolidation procedures for subsidiary
companies with preferred stock in their capital
structure.
2. Calculate basic and diluted earnings per share
for a consolidated reporting entity.
3. Understand the complexities of accounting for
income taxes by consolidated entities.

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Subsidiary Preferred Stock, Consolidated Earnings Per

Share, and Consolidated Income Taxation

1: Preferred Stock

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Subsidiary Preferred Stock

Subsidiary preferred stock
Doesn't change consolidation in principle
Does impact calculations
Common stockholders' equity = total equity less
preferred stock at book value
Income of subsidiary is first allocated to preferred
shareholders, then CI and NCI
Subsidiary dividend payments must consider
payments to preferred shareholders before
common shareholders

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Who Holds Preferred Stock?

Preferred stock is held by outsiders
Preferred stock is a noncontrolling interest
Preferred stock is held by parent
May choose between
Constructive retirement
Cost basis

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Review of Preferred Stock

Characteristics
Callable, redeemable
Cumulative or noncumulative
Participative or nonparticipative
Limited voting rights
Most is cumulative and
nonparticipating
Book Value of PS is:
Call or redemption price (par
value if neither)
Plus Dividends in arrears (if
cumulative)

Income allocated to PS is:

Current period dividend
Irrespective of amount
declared, if cumulative
Declared amount if
noncumulative
Potentially more if
participative
Preferred stock dividend is:
Face value x dividend rate
Also consider:
Arrearage
Participation

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Example: PS Held by Outsiders

Poe buys 90% of Sol for $396 when Sol's equity
consists of $100 preferred stock, $200 common
stock, $40 other paid in capital and $160 retained
earnings.
The preferred stock is cumulative, nonparticipating,
carries a 10% dividend and is callable at 105% of
par value. There is no arrearage.
During the year, Sol earns $50 and pays $30 in
dividends.

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Calculations for Preferred Stock

Cost of 90% of Sol

$396

Implied value of Sol

$440

Sol's total equity

$500

Less book value of preferred stock

(105)

Book value of common

395

Excess, goodwill

$45

The book value of preferred is its call price (no

arrearage), 105%($100 par value).
Dividends are cumulative, so the current dividend is
$10 = 10%($100 par value).
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Allocations
NCI share
Preferred

Income allocation:
Sol's net income
Amortizations
Income to allocate

50
0
50

Allocated to preferred

(10)

Allocated to common

40

$10 income
$10 dividend
CI share
(90%)

NCI share
(10%
common)
$4 income
$2 dividend

$36 income

Dividends

30

Allocated to preferred

(10)

Allocated to common

20

$18 dividend

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Worksheet
Entries
with
Preferred
Stock Held
by
Outsiders
There is an
entry for NCI
share, PS that
parallels the
entry for NCI
share, CS.
Preferred Stock
is eliminated.

Income from Sol

36

Dividends

18

Investment in Sol

18

Noncontrolling interest share, CS

Dividends

Noncontrolling interest, CS

Noncontrolling interest share, PS

10

Dividends

10

Preferred stock

100

Common stock

200

Other paid in capital

Retained earnings
Goodwill

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40
160
45

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Parent Uses Constructive Retirement

Parent acquires subsidiary's preferred stock
Investment in subsidiary, PS is recorded at its book
value
Any difference between book value and cost of the
stock is an adjustment of other paid in capital
This is an owner transaction; no gain or loss is
recorded
Investment is carried at PS book value
Increase for dividends in arrears
Decrease later when declared

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Parent Uses Cost Basis

Parent acquires subsidiary's preferred stock
Use cost method
Investment in subsidiary, PS is at cost
Dividends are recorded as income
In the consolidation process
Preferred stock is eliminated at its book value
Noncontrolling interest, PS is recorded at book
value of the preferred stock held by others
Investment is removed at its cost and any
difference from book value is charged or credited
to other paid in capital

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Example: Parent Acquires PS

Plato owns 80% of Shem acquired at fair value
plus implied goodwill of $100.
On 1/1/09 Plato acquires 70% of Shem's
outstanding preferred stock at $950.
Shem's equity at 1/1/09:
$3 Preferred stock, $50 par, callable at
$52, cumulative, no arrearage
Common stock $1 par

1,500
300

Other paid in capital

1,200

Retained earnings

2,300

Total equity

5,300

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Calculations
Book value of preferred stock
$52 x ($1,500 / $50par) = $1,560
Book value of Shem's common stock
$5,300 total equity $1,560 = $3,740
Shem's total value with goodwill
$3,740 + $100 = $3,840
Investment in Shem, CS (80%) = $3,072
Noncontrolling interest, CS (20%) = $768
Noncontrolling interest, PS (30%) = $468
Parent acquired 70% of Shem's PS for $950
Investment in Shem, PS (70%, book) = $1,092
Or
Investment in Shem, PS (70%, cost) = $950
The difference, $142 = 1092-950, increases the parent's other
paid in capital
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Constructive Retirement Entries

Parent's acquisition entry:

Investment in Shem, PS (70%)

1,092

Cash

950

Other paid in capital (Plato)

142

Worksheet entry:

Preferred stock
Common stock

1,500
300

Other paid in capital

1,200

Retained earnings

2,300

Goodwill
Investment in Shem, CS (80%)

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100
3,072

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Cost Basis Entries

Parent's acquisition entry:

Investment in Shem, PS (70%)

950

Cash

950

Worksheet entry

Preferred stock
Common stock

1,500
300

Other paid in capital

1,200

Retained earnings

2,300

Goodwill
Investment in Shem, CS (80%)
Investment in Shem, PS (70%)

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100
3,072
950

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Comparison of Methods
Both result in the same consolidated amounts
Constructive retirement
Records the Other paid in capital (parent's) at
acquisition
Investment is at book value
Simplifies consolidation process!
Cost basis
Records the Other paid in capital (parent's) as part of
the consolidation process
Investment is at cost

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Subsidiary Preferred Stock, Consolidated Earnings Per

Share, and Consolidated Income Taxation

2: Earnings Per Share

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EPS Requirements
GAAP requires firms report basic and diluted
(where applicable) EPS
EPS is disclosed on a consolidated basis
Main issue: Subsidiary's capital structure
Subsidiary potentially dilutive securities
convertible into subsidiary common stock
Subsidiary potentially dilutive securities
convertible into parent common stock
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Review Basic EPS

Numerator:
Net income preferred stock dividends*
* current dividends if cumulative, otherwise declared
dividends
Denominator:
Weighted average shares of common stock

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Review Diluted EPS

Numerator:
(Net income PS dividends)
+ adjustments for dilutive securities
Denominator:
Weighted average shares outstanding
+ shares represented by dilutive securities
Dilution:
Dilutive securities reduce EPS.
Non-dilutive securities are excluded
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Review Dilutive Securities

Convertible bonds
Numerator: after tax interest expense
Denominator: common shares bonds represent
Convertible preferred stock
Numerator: preferred stock dividend
Denominator: common shares the preferred
shares represent
Convertible preferred stock
Numerator: none
Denominator: "treasury stock method" to
compute shares (if positive)
# shares (# shares x option price / market price)

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Subsidiary Securities Convertible

into Subsidiary Common Stock
Compare Parent's equity
Realized earnings of subsidiary
Diluted earnings of subsidiary
If diluted is higher, skip Non-dilutive
Realized earnings:
Subsidiary's net income adjusted for intercompany
profits/losses
Does not include amortizations of valuation differentials
Diluted earnings:
Subsidiary's diluted EPS x number of shares
Parent's diluted EPS
Numerator: Reduce by difference
Denominator: No effect no parent shares!

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Subsidiary PS Convertible into

Subsidiary CS
Seed has $50 net income and 20 weighted average
shares of common stock. Its preferred stock has
a $10 dividend and is convertible into 12 shares
of Seed common stock.
Seed's basic EPS:
($50 - $10) / 20 = $2.00
Seed's diluted EPS:
($50 - $10) + $10 = $1.5625
20 + 12
.
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Parent's Basic EPS

Seed is 90% owned by Plant. Plant's net income is
$186, 200 shares of common are outstanding all
year, and Plant has no dilutive securities.
Plant's basic EPS:
$186 / 200 = $0.93

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Parent's Diluted EPS

Plant's realized income from Seed
90% x $40 = $36
Plant's share of Seed's diluted earnings:
90% x 20 shares x $1.5625 = $28.125
Since the share of diluted earnings is lower, we will
reduce the numerator by the difference.
Plant's diluted EPS:
$186 36 + 28.125 = $0.89
200
.
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Subsidiary Securities Convertible

into Parent Common Stock
Parent's diluted EPS calculation:
Numerator: Add adjustments for subsidiary
securities convertible into parent common
stock
Denominator: Add parent common shares
represented by subsidiary's dilutive securities

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Subsidiary Options and Bonds

Convertible into Parent CS
Syd's net income is $450 and it has 400 shares of
common outstanding all year.
Options: Syd has options that convert into 60
shares of its parent's (Paddy) common stock at
$10 per share. The average market price is $15.
Convertible bonds: Syd has $1,000 par bonds
convertible into 80 shares of Paddy's common
stock. The bonds were issued at par to yield 7%.
The effective tax rate is 34%.
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Parent's Data and Basic EPS

Paddy has $1,800 income and 1,000 shares of
common stock outstanding all year. It has no
preferred stock or dilutive securities.
Paddy's basic EPS:
$1,800 / 1,000 shares = $1.80

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Parent's Diluted EPS

Impact of Syd's options for Paddy common:
Numerator: none
Denominator: 60 + (60 x $10/$15) = 20 shares
Impact of Syd's bonds convertible to Paddy common:
Numerator: 7% x $1,000 x (1-34%) = $46.2
Denominator: 80 shares
Paddy's diluted EPS:
$1,800 + 0 + $46.2 = $1.76
1,000 + 20 + 80
.

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Subsidiary Preferred Stock, Consolidated Earnings Per

Share, and Consolidated Income Taxation

3: Income Taxes

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Consolidated Tax Return

Advantages
Offset affiliate losses (excluding preacquisition
loss carry forwards)
Exclude intercompany dividends
Defer intercompany profits until realized
(losses are also deferred)
Disadvantages
Loss of flexibility
Difficult to switch back to unconsolidated
Cannot file as consolidated again for 5 years

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Income Tax Allocation

Permanent differences
Dividends from affiliates are excluded from
taxable income
Dividends from affiliates that are not members of
the affiliated group are allowed an 80% dividends
received deduction
Temporary difference
Undistributed income from domestic affiliates
(FASB Statement No. 109)
Undistributed income from foreign affiliates and from
domestic affiliated earnings preceding FASB
Statement No. 109 may be permanent.

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Undistributed Earnings
Parson owns 30% of Seaton's common stock.
Seaton's income, $600
Seaton's dividends, $200
Parson's applicable tax rate = 34%
Parson's deferred tax liability
= [30%($600 - $200)] x 20% x 34% = $8.16
Seaton's earnings are allowed the 80% deduction,
so only 20% is subject to tax.
If Seaton was a consolidated subsidiary, its
earnings would be excluded and Parson would
have no deferred tax liability.
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Unrealized Profits and Losses

Separate tax returns
Unrealized gains (losses) are taxed (deducted) in the
separate returns
Consolidation procedures
Remove the unrealized gain (loss)
Record a deferred tax asset (liability)
Tax effect impacts the income tax expense of the
selling affiliate
Consolidated tax return
Unrealized gains (losses) are excluded

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Example
Pool owns 90% of Sal. The tax rate is 34%. Pretax
operating income of Pool and Sal are $150 and $50. Sal
paid dividends of $20 and Sal's dividends are subject to
the 100% exclusion.
During the year, intercompany sales were $50 and there
remains $10 in unrealized profits in ending inventory.

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Consolidated Tax Return

Downstream sales
Pool's income $150 - $10 = $140
Sal's income $50
Consolidated taxes ($140 + $50) x 34% = $64.6
Allocate
(140/(140+50)) x $64.6 = $47.6 to Pool
(50/(140+50)) x $64.6 = $17.0 to Sal
Upstream sales
Pool's income $150
Sal's income $50 - $10 = $40
Consolidated taxes ($150 + $40) x 34% = $64.6
Allocate
(150/(150+40)) x $64.6 = $51.0 to Pool
(40/(150+40)) x $64.6 = $13.6 to Sal

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Entries with Consolidated Return

Pool and Sal would each record their own share of the
income tax expense and income tax payable.
The unrealized profit does not give rise to any
temporary differences
Deferred for consolidation purposes
Deferred for tax purposes
That is, it is not income now and it is not taxed now!
No special considerations for consolidation worksheet.

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Separate Tax Returns

Downstream sales
Pool's accounting income $150 - $10 = $140
Pool's taxes payable $150 x 34% = $51.0
Pool's deferred taxes $10 x 34% = $3.4
Income tax expense $47.6
Sal's income $50
Sal's taxes $50 x 34% = $17.0
Upstream sales
Pool's income $150
Pool's taxes $150 x 34% = $51.0
Sal's income $50 - $10 = $40
Sal's taxes payable $50 x 34% = $17.0
Sal's deferred taxes $10 x 34% = $3.4
Sal's income tax expense $13.6

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Business Combinations
Tax free combinations
Mergers or consolidations
Exchange of voting stock for another
corporation's stock
Exchange of voting stock for another
corporation's assets
Purchase acquisitions may be either
Tax free
Taxable
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Tax Free Business Combinations

Tax free business combinations give rise to differences
between book values and tax values
At acquisition
Assign assets value based on gross fair value
Except
Goodwill, bargain purchase, deferred taxes,
pension assets, leveraged leases
Tax bases carry forward from predecessor
Record deferred tax asset/liability for temporary
differences

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Copyright 2009 Pearson Education, Inc.

Publishing as Prentice Hall
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